Emerging markets: is the engine for oil demand set to stall?

Although oil demand is growing rapidly in India, the pace of expansion has moderated in other emerging markets including China and Brazil. As demand from emerging markets is vital in the global context, might the risks to the oil price be on the downside in 2017?

An apparently striking turnaround in oil market dynamics – with a shift towards a reflationary environment in the US, strong demand from select emerging markets and OPEC committing to its first production cuts since 2008 – has helped keep the oil price back above US$50. Forecasts from the International Energy Agency (IEA) suggest that if OPEC members maintain their commitments to pare back production, the market is likely to move from surplus to deficit in 2017.

Figure 1: Oil market dynamics: The balance of supply and demand

Source: International Energy Agency, as at 13 December 2016

Nevertheless, a number of factors might curtail the upward price trend, including a rapid expansion of supply. While OPEC members grapple with capacity reduction, other producers worldwide are bringing facilities on-stream. Rig counts are increasing again, with a sharp step up in the US.

Figure 2: Oil supply dynamics: rig capacity is building again

Source: Baker Hughes, Worldwide Rig Count, as at January 2017

“President Trump is committed to reducing the reliance on external energy supplies and ‘making American energy great again’,” says Lei Wang, Senior Research Analyst at Aviva Investors. “Output is expected to increase significantly. There is additional capacity that can be brought on-stream, particularly by shale oil producers in the Permian basin. Shale producers are using new technologies that are faster to deploy and can bring capacity online in just six months. In my view, reality will start to bite in the second half of the year. The ramp up in production will show obvious results in inventory.”

Elsewhere, there are other long-planned projects coming on stream in Australia, Brazil, Canada and Kazakhstan, while productivity could also step up in Colombia. ”This increase [in output] could be supplemented by higher production from Libya and Nigeria, both of which are exempt from OPEC production cuts,” as the IEA points out.1

Meanwhile, the outlook for demand growth is not clear. Energy efficiency is increasing, and a gradual shift in the fuel mix (away from coal and oil, towards gas and renewables) is expected to lead to slower growth in the future.

Emerging markets have been the engine of growth in the past decade, drawing on oil and related products for transport and the production of petrochemicals and plastics, while OECD demand has declined. China is currently the world’s largest oil importer, but demand is expected to grow less rapidly in the future as it focuses on cleaner fuels and rebalancing its economy2. India has replaced it as the world’s fastest growing energy market3, following a similar trajectory to China as it industrialised just over a decade ago; calls for transport fuels and naphtha and ethane for petrochemical projects are driving demand. Other markets like Brazil are using tax incentives to tilt consumers towards petroleum alternatives, such as ethanol produced from sugar cane.

Figure 3: Emerging markets: driving oil demand

Consumption of petroleum and other liquid hydrocarbons

Source: US Energy Information Administration, 2016 estimate, as at 7 February 2017

China’s role as a key oil buyer

Wang believes demand from China is the key swing factor that will determine the oil price trajectory in the near term. China has been taking advantage of lower oil prices to build its Strategic Petroleum Reserve - an oil supply buffer for use in emergencies - in both 2015 and 20164. Although the scale of purchases is difficult to determine, state buying was estimated to be broadly equivalent to the total global increase in crude demand last year. The country has also begun a crackdown on privately owned ‘teapot’ refiners in an effort to increase the government’s tax take. That has the potential to reduce their profitability, cut throughput and reduce overall demand.

Combined demand to fill strategic reserves and from China’s ‘teapot’ refiners is thought to be larger than OPEC’s planned production cuts (approximately 1.2 million barrels per day). Slower strategic inventory building and a reduction of perhaps 30 per cent to 50 per cent of demand from China’s private refineries would remove important pillars of price support.

Protectionism

Meanwhile, early indications suggest US President Donald Trump may seek to impose tariffs on imports from Mexico and potentially Saudi Arabia to promote the US energy complex. Although the president could impose temporary tariffs of up to 15% for 150 days on specific goods, establishing permanent tariffs would require congressional action. “If non-US producers face higher tariffs getting their product into the US, they may seek to sell elsewhere and end up selling at discount,” says Wang. “Tariffs could also have a negative impact on refiners if they force up the cost of feedstock in the US, or lead to retaliatory action against petroleum-based exports from it.”

Other important variables include the relative weakness of local currencies against US dollar, which has intensified since the US election. Putting countries with established pegs to the US dollar aside, emerging market currencies are trading well below longer term averages, diminishing their purchasing power.5

Valuation implications

These complex scenarios create an environment where there is a huge divergence in expectations, partly due to the way in which the economics of production change in response to price. Projections from the US Energy Information Agency include a ‘high oil price’ scenario, built on estimated GDP growth of 2.6 per cent annually, with Brent crude reaching over $150 a barrel by 2020, then lifting over $200 by 2040. Conversely, a conservative ‘low oil price’ scenario suggests prices might drift around $40 dollars for another two decades, shown below.

There are certain vulnerabilities investors need to be aware of in the more cautious scenario. “Oil prices in the low-to-mid $50 range are enough to stop many exploration and production companies bleeding cash”, says Wang, “but it is still not enough to break even for most others. We expect oil prices to be in the $50-$55 range for the first few months of 2017, and then to potentially head lower.”

Although direct price exposure varies across production chains, a downward shift in the oil price would be reflected in equities. At the moment, forward earnings expectations are positive and sector valuations have improved significantly in the past year. The MSCI ACWI Energy Index, which covers both developed and developing markets, has appreciated by almost one third in that period.6

In fixed income, energy makes up a significant part of both the investment grade and high yield debt indices. Stronger issuers have taken advantage of the low cost of debt to maintain or increase payouts to shareholders or undertake acquisitions, while weaker credits have issued secured debt to maintain liquidity. Here, the market’s perception of risk has also fallen away; in high yield, US energy defaults are expected to end the year at around 3.3 per cent, down from over 18 per cent in late 20167, and the spread on US high yield debt has narrowed back towards the high yield benchmark.8

Figure 5: US energy high yield spread narrows

Nevertheless, there are reasons for caution in a cyclical, capital intensive industry where some operators have elevated leverage and are burning cash. Even in the context of better-than-expected data from around the world, further weakness in the oil price cannot be ruled out. Greater protectionism, another supply shock, non-compliance by members of OPEC with planned capacity reductions and a dip in emerging-market demand are all possible outcomes in 2017.

1 International Energy Agency. Key Oil Trends 2016

2 Bloomberg. Solving the Puzzle of China Oil Demand, as at 12 December 2016

3 The Oxford Institute for Energy Studies. India’s Oil Demand: On the verge of ‘Take-Off’?, as at March 2016

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at February 21, 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

Aviva Investors Global Services Limited, registered in England No. 1151805. Registered Office: St Helen’s, 1 Undershaft, London EC3DQ. Authorised and regulated by the Financial Conduct Authority and a member of the Investment Association.

This article is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited and its subsidiaries Aviva Investors Securities Investment Consulting Co., Ltd. and Aviva Investors Pacific Pty Ltd (“Aviva Investors Asia”) for distribution to institutional/wholesale/professional investors only. Please note that Aviva Investors Asia does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Asia in respect of any matters arising from, or in connection with, this document.

For use In Singapore

Issued by: Aviva Investors Asia Pte. Limited, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and is an Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1 Raffles Quay, #27-13 South Tower, Singapore 048583.

Issued by: Aviva Investors Pacific Pty Ltd, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 50, 120 Collins Street, Melbourne VIC 3000, Australia.

Compliance Code: 20170221_02

Lei Wang, Senior Research Analyst at Aviva Investors, contributed to this insight

Lei Wang

Senior Research Analyst

Main responsibilities

Lei is responsible for investment grade and high yield credit analysis on energy, diversified manufacturing and other industrials.

Experience and qualifications

Prior to joining Aviva Investors, Lei was Vice President at Morgan Stanley Investment Management. Previously, Lei has been a senior analyst for Paulson & Co Inc., a director at Deutsche Bank and Vice President at JP Morgan Asset Management, with a focus on investment grade and high yield investments on energy and basic materials. She began her career with Bear Stearns & Co. as an associate covering Latin America and Asian emerging markets credits.
Lei graduated with a BA in business administration from Queens University of Charlotte and holds an MBA in finance from Columbia Business School.